3 Tips to Beat Income Tax on Retirement Accounts

When doing estate planning, can you get more out of your retirement accounts for your heirs?

These days clients commonly have large portions of their estates in retirement accounts. Many have contributed to their accounts during their working years, and have enjoyed employer matching contributions and decades of tax-free growth. Unlike with a Roth account, distributions from a traditional account are taxed as ordinary income. Compounding this problem in recent years was the passage of the SECURE Act in 2019, which eliminated the ability of most beneficiaries to stretch their distributions over a favorable period of life expectancy. Now most beneficiaries inheriting a retirement account must empty the account in no more than 10 years, thereby losing the benefit of tax-deferred growth enjoyed by those who inherited prior to the Act.

Because income tax can eat up a large portion of the distributions, especially for beneficiaries in the highest income tax bracket, you should consider some alternatives when doing your estate planning.

This video offers a few tips. Watch the recording, or follow along with the transcript below.

Hi, Welcome to Estate Planning Blueprint. I’m Andrew Sykes and today we’re going to be talking about retirement accounts in estate planning, and particularly the problems that you might have with traditional retirement accounts as opposed to Roth retirement accounts.

What is the difference between a Traditional IRA and Roth account when estate planning?

The difference there is that with a traditional IRA or 401(K) or 403(B), there’s been no tax withheld, and the amounts have just accumulated and grown tax-free for the employee for years. As a result then, when you take the money out eventually, the money comes out and it’s ordinary income. Whereas, with a Roth, the tax is paid upfront, so that when you take a distribution out, it’s taken out tax-free. Also, you don’t have the same requirement for required minimum distributions. With the traditional one, at age 72 these days, it’s required that you take out a certain amount according to your life expectancy every year.

So those are the differences with a traditional and a Roth. The reason it make a difference in estate planning is that because you have the amount coming out for taxes is it’s coming out not only for the individual whose retirement it is, but also for any beneficiaries. So during your lifetime you’re going to deal with the issue of taxes and then if you’re leaving it to your beneficiaries they are going to be taking out tax which could be pretty significant. Especially if they happen to be in their prime earning years at the time they inherit it. They could be taxed perhaps, at the highest rate, so a substantial amount of this asset is going to be subject to income tax.

Secure Act of 2019

Another reason why it’s important these days is that back in 2019, Congress passed the Secure Act, which changed the way people inherit IRAs, 401(K)s, 403(B)s, all those qualified retirement accounts. Before the Act, beneficiaries were allowed to take it out on a very favorable timeframe – they could take it out according to a very favorable life expectancy table, and as a result just take out a small required minimum distribution each year and leave most of it growing tax-free. So a result, if it was a fairly substantial retirement account that they were inheriting they could grow for a long time tax deferred while they’re just taking out a little bit each year so that it was very favorable.

That changed under the Secure Act, so now for most people who are inheriting retirement accounts, they’re going to have to take it out over 10 years. Not everybody, there are some exceptions, but for a lot of people who inherit retirement accounts it’s that 10 year timeframe. You don’t get to stretch it anymore, you have that 10 year period within which to take out all of the funds, so you get this big tax issue.

That’s why retirement accounts are different from other accounts that people might have when we are doing their estate planning, like their brokerage accounts, their savings and checking, all those kinds of things that are already assets that taxes have been paid on. So this offers a challenge but it’s also an opportunity to provide some great creative solutions to people to address this issue about income tax and distribution on an accelerated timeframe.  What are some alternatives that we can think about?

Strategy #1: Roth Conversion

One is to always consider a Roth Conversion for people. And what that means is that with a Roth Conversion, if you have a traditional retirement account you convert it to a Roth account that we talked about before. Let’s say you did that this year with a one million dollar IRA, and I want to convert that to a Roth IRA. What that would mean is I’d have to pay the tax on it this year. So, if I have money from some other account and could pay three or four hundred thousand dollars to convert a one million dollar IRA in a single year, then that’s the strategy of converting it – is that you’re paying the tax now. And the idea is that once I’ve paid that tax this year, now when I take out distributions later, and particularly when my beneficiaries take out their distributions later on, nobody’s paying income tax on that. Also, I don’t have the same requirement for required minimum distributions, so it’s not being reduced every year once I get to age 72. So as a result, if I live long enough and don’t need that account, the ideas is it can grow tax-deferred the way retirement accounts do, but not be diminished by the required minimum distributions. And if we pay the taxes now, eventually as it grows, the idea is in the long run maybe it’s going to mean more money for the beneficiaries.

Now I qualified that a bit by saying maybe, so the thing I want to emphasize with Roth conversions is that you always want to get a qualified financial advisor to determine whether or not it’s a good idea in this particular situation. If you have a client that you think might benefit from a Roth conversion, always get somebody that can run those projections and scenarios and make some reasonable assumptions about market growth and so on in the future, and see if it really makes sense for that client. It’s not for everybody, but for those clients that it is good for, it can be a real tax saver. So that’s one thing to consider.

As an estate planning attorney, I don’t do Roth conversions myself, but you know partner with somebody who is qualified to do the financial part of it and then you can really perhaps benefit your client. It’s a big value add for them but there’s that tax savings and it’s something that you definitely want to spot the issue on.

Strategy #2: Life Insurance Conversion

Another alternative to just leaving things the way they are – leaving people have these tax consequences – is to consider converting it to life insurance. You might be familiar with a financial advisor by the name of Ed Slot. He had a show on PBS for a number of years and wrote a book called The Retirement Savings Time Bomb and How to Defuse It, and he writes a whole chapter on converting IRA’s and 401(K)’s to life insurance. This can be a big tax saver too because life insurance passes income-tax-free. Let’s take an example, let’s say someone has a one million dollar IRA and they’re age 60 and in pretty good health and it turns out that because they have other income that they expect to have during their retirement, they’re not really going to use that IRA for their day-to-day expenses and they’re not going to need the income from it to live on. They just want to have it go to their beneficiaries in the most tax-advantaged way that they can. So the idea would be to get an insurance quote, and maybe with life insurance at age 60 you might get a policy worth at least what it’s worth now, a million dollars in the IRA. And maybe it’s even two or three million if the person’s in good health. So you get the life insurance policy and you pay for it with after-tax distributions from the IRA. In other words, you might get a fully paid-up life insurance policy, let’s say worth 2 million would not be unreasonable for somebody at age 60, and you would pay for that by having them take out enough distributions to pay for the premiums each year. Then, at the end you’ve exhausted the IRA, but you have a fully paid-up life insurance policy. And now, unlike the IRA which would have all these tax consequences, the two-million-dollar life insurance policy is going to pass tax-free. So, you’ve solved that income tax problem for the client, and you might have also solved other problems too.

For example, in Pennsylvania people are subject to the Pennsylvania Inheritance tax and if that client with a one million dollar IRA died, let’s say at age 80, when they were already subject to minimum distributions that would be taxable, they would pay inheritance tax. Four and a half percent for children, 12 percent if it was going to siblings, 15 percent for nieces and nephews, that sort of thing. If you’re in a state like that and life insurance is not taxable like it is in Pennsylvania, we pay no inheritance tax on life insurance, solve another problem not only save the income tax save the inheritance tax as well.

Another thing that you can look for – does the client have a federally taxable estate? So if they are subject to federal estate tax, then you can think of taking the life insurance policy and putting it into a Irrevocable Life Insurance Trust (ILIT). After a few years, that will not be subject to federal estate tax, so now you’ve saved another set of taxes for your client, taking care of the income tax and maybe save them from federal estate tax too. So, converting to life insurance can be a very effective method of addressing this income tax issue in retirement accounts. 

Strategy #3: Charitable Remainder Trust (CRT)

Another approach to consider is the Charitable Remainder Trust (CRT). So these are sort of making a come-back after the Secure Act, because people are trying to find an alternative to that 10-year time limit on making distributions, and charitable remainder trust is a way to do that. Let’s take another example – let’s take the one million dollar IRA and we’ll assume that we have a client that’s charitably inclined and doesn’t need this money maybe to live on. And they’re going to assume that when they die they have a one million dollar IRA that would lead to a charitable remainder trust. We’ll also assume this client has one daughter who is the sole heir, so they would set it up for example to pay out over 20 years. So we’ll say we’re going to leave it to a charitable remainder trust, and it pays the daughter five percent of the value of that IRA per year for the next 20 years. We’ll also make another assumption – we’ll assume 7 percent average growth on the IRA – if that’s the case, then there will definitely be enough to pay for the five percent a year and still have something left over at the end. We’ll have at least the one million dollars we started with to leave to a charity. So it’s kind of like you’re leaving it twice – you’re leaving the one million dollars plus, because they’re getting five percent a year, and then if it’s growing at seven percent, the principal will increase. The five percent a year will increase over time as the retirement account continues to grow in the trust, so the daughter will have gotten at least a million dollars, and then the charity will have gotten a million dollars as well. For people that have a favorite cause that they’re passionate about, that can be a great way to accomplish a couple things that they’re still benefiting one of their loved ones but they’re also benefiting this cause that they care about.

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